Carry trade sought

Tue, Jul 27 2010, 05:09 GMT
by Kenneth Broux

Market Outlook

Tactical view:

= Carry trade sought

A decline in US 3-month libor below 0.50% coupled with solid Q2 company earnings have buoyed demand for carry trade strategies, driving high yielding and commodity currencies through key resistance levels vs the USD. It is debateable how long momentum can be sustained in a context of faltering momentum in the US. The idea that additional policy stimulus by the Fed could be required and would re-flate risk assets appears misplaced when elsewhere fiscal stimulus is withdrawn and liquidity is unwound. With the EU bank stress tests finally behind us, we look ahead to a G10 calendar next week dominated by the MPC testimony to the TSC and the first estimates of US Q2 GDP. Month-end implies currency and bond portfolio rebalancing. In five of the last six months, the re-weighting resulted in EUR/USD firming an average 0.5%. In contrast, GBP/USD only gained in month-end fixings in March and May.

Recap

The recap for fx this week reads very similar to that of two weeks ago. A rally in global equities propelled the AUD to the top of the G10 table, helping the currency to gains of 3.3% vs EUR, 2.6% vs USD and 2.5% vs GBP. A 1.1% q/q jump in UK Q2 GDP boosted GBP and helped the pound to record a 1.3% gain vs the JPY and 1.2% vs the EUR. GBP/USD ended the week above 1.5350, having traded as high as 1.5450. EUR/USD was equally unable to cling on to the best levels above 1.29 as profit taking emerged on the release of the EU bank stress tests following earlier bidding on a 3-year high for the German IFO.
UK Q2 GDP surpassed the most bullish estimates as the ONS reported a 1.1% q/q jump in output vs 0.3% in Q1. This still leaves the economy 4.7% below the starting pointof the recession in 2008, and will not tempt the MPC to change its view that the economy may weaken in the second half of 2010. The MPC minutes were remarkably more dovish on growth and members Posen and Dale did not hold back to warn of the dangers ahead. Retail sales also beat consensus estimates by climbing 1% in June. A marked decline in the retail deflator to 1.3% and a fall in inflation expectations back below 3% will comfort the MPC about the inflation outlook. Public finances recorded a bigger deficit in June, with borrowing reaching £14.5bln and data for May revised up to £17.0bln.
A good start to the week for UK rates reversed on Friday on the strong GDP release, causing yields to end the week on a high. 5y swaps climbed to 2.47%, up 6bp on the week. 10y yields rose above 3.40% to a 3.43% high. A deceleration in inflation pressures should keep yields capped going into August, with downside risk to the US macro data providing better levels to buy. The 3mth Libor/Ois spread widened one bp to 24bp. The 2y/10y swap spread widened 2bp to 198bp, and 10y swap spreads stayed flat at 2bp. A disappointing 2016 gilt sale drew lower than previous cover of 1.38x (1bp tail).

G10 FX - GBP/USD, ST trend still bullish

Back in June we noted that by flirting with a return to the 1.4784- 1.55 trading range in place between February and May, GBP/ USD had approached a crossroads, and how an improved technical picture and a rebound in correlations with equities and commodities pointed to further upside in the short-term (1.54 topside). This week we review our call and state that even though GBP/USD has posted impressive gains in July, there is no compelling case to drop the bullish near-term picture. Though the correlation of GBP/USD has eased back to statistically insignificant levels since the June comment (see chart), the divergence between UK and US macro indicators (see chart) brings the potential of further upside over the coming weeks before potential profit taking sets in ahead of the August MPC meeting and the Inflation Report on August 11.

The retreat of USD crosses since June has been led by a net change in speculative positioning and is marked by a net reduction in short JPY, EUR and GBP contracts. Disappointing US macro data since June has added downside USD pressure and is fuelling talk that the Fed may engage in a new round of policy stimulus in Q3/Q4 to prevent the economy from losing further steam. Though the jury is out whether the Q2 slowdown is a blip or start of a downtrend, a decline in US 3-mth libor below 0.50% and a rally in short-dated FF futures curve indicates that the market is taking a more pessimistic view. Additional US measures would threaten to drag the USD lower vs non-QE currencies or currencies where exceptional measures are gradually phased out.

Though strong UK Q2 GDP (+1.1% q/q) took the market off guard and lifted GBP/USD above 1.54, one cannot ignore the dovish observations by the MPC and individual comments by members Posen and Dale. This could lead investors to re-engage in accumulating GBP short positions into early August. To what extent the Budget will bear down on the Bank’s growth and inflation forecasts will become clear in the next Inflation Report. Minutes from the July MPC meeting hint that growth prospects may be scaled back. Depending on whether inflation and inflation expectations also recede, talk of additional policy loosening (a greater than 50% probability accordng to MPC member Posen) would cloud the outlook for GBP vs other G10 currencies, especially those where performance is linked to positive interest rate spreads and elevated correlation with equities and commodities.

Based on our quantitative metrics, the correlation of GBP/USD with risk assets has receded markedly to the point that price action in stocks has become statistically insignificant for short term direction. Rate differentials between the US and the UK have also faded as a driver for GBP/USD, offering no clear sense of direction for the cross. Though we are tracking changes in correlations closely, this means is that markets are inclined to put more weight at present on corporate flows and a divergence between US and UK macro indicators, but with confidence about deficit reduction equally playing a part.

Technically, to sustain the upward short-term move GBP/USD has to overcome 1.5454, the July 15 high. Beyond 1.55 lies a cluster of resistance at 1.5524 and 1.5578. A breakout of the February- May range would bring 1.5814 into play.

GBP/USD: technicals still bullish; 1.5500-1.5578 within reach